BKEAY Bank East Asia Ltd (PK)

By Frances Yoon and Joanne Chiu 

For years, Hong Kong has been one of the world's most profitable banking markets. That status is now under threat.

The city is a money-spinner for HSBC Holdings PLC, Standard Chartered PLC, Bank of China (Hong Kong) Ltd. and others, such as Bank of East Asia Ltd. and HSBC's local subsidiary, Hang Seng Bank Ltd. It is lucrative in part because Hong Kong is a major financial center, and handles a lot of business for mainland Chinese clients.

Banks' profit per employee last year was higher in Hong Kong than in any other market tracked by Citigroup analysts -- roughly double the U.S. figure.

But now Hong Kong's economy is shrinking, hit by the U.S.-China trade war, slowing Chinese growth and months of antigovernment protests. Earlier this month, the city's chief executive, Carrie Lam, said Hong Kong was in a "technical recession," typically defined as at least two straight quarters of economic contraction.

A weaker economy is likely to mean more loans going sour and less credit demand from households and businesses.

Meanwhile, lending is becoming less profitable, as the city's currency peg with the U.S. dollar forces it to match interest-rate cuts by the Federal Reserve. Lower interest rates typically reduce the margins banks earn, by narrowing the gap between the rates at which they lend and borrow. To make things worse, there is new competition from upstart online banks.

"It's the start of the end of an era of super profitability in Hong Kong, " said Ronit Ghose, the Dubai-based global head of bank research at Citigroup.

Quarterly results this week -- from HSBC on Monday and Standard Chartered on Wednesday -- will give investors an early indication. The two are both listed on the London Stock Exchange as well as in Hong Kong.

The banks face other challenges, too. For HSBC, these include uncertainty over the U.K.'s planned exit from the European Union and trouble with officials in China, angry over its giving U.S. prosecutors information about client Huawei Technologies Co.

But Hong Kong matters hugely: It provided roughly half of HSBC's pretax profit in the second quarter.

For the third quarter, consensus forecasts compiled by HSBC point to an 11% drop in net profit from a year earlier, to US$3.47 billion. Expected credit losses and other credit-impairment charges are forecast to be up by nearly one-third, to US$673 million.

One focus for HSBC watchers will be cost-cutting plans, said Gary Greenwood, a U.K.-based analyst at Shore Capital Group, since the bank has pledged to increase revenue faster than costs this year.

Now comes the virtual competition. The Hong Kong government this year granted eight licenses for online banks, which won't need physical branches. Backers include powerful technology companies -- among them Tencent Holdings Ltd. and Ant Financial, an affiliate of Alibaba Group Holding Ltd. -- as well as such traditional lenders as Bank of China (HK), Standard Chartered, and Industrial and Commercial Bank of China Ltd.

Felix Lam, a portfolio manager at BNP Paribas Asset Management, said traditional banks' defense of market share could lower fee income and raise the cost of attracting new deposits.

Hang Seng, HSBC, and Standard Chartered will feel the most pressure from stiffer competition in the retail market, Morgan Stanley analysts wrote in a note to clients, since about half their Hong Kong earnings come from retail.

Shares of Hong Kong-focused banks have underperformed the broader Hong Kong market this year. HSBC trades at 0.91 times the forecast book value of its assets, according to FactSet, below a 10-year average of 1.05 times. Trading below book value can signal investor concerns about capital strength or future profitability.

Despite the low valuation, analysts and investors don't see the stock as a bargain. Refinitiv tallies analysts' recommendations on a five-point scale: 1 is a strong buy, 3 a hold and 5 a sell. HSBC is currently at 3.3, the most negative since 2002.

Analysts don't expect overall profit to fall at HSBC, but neither do they expect rapid growth. The consensus of the forecasts collected by the bank is for an income rise of just 0.3% next year, to US$14.44 billion, and about 5.2% in 2021.

Mr. Lam at BNP Paribas Asset Management said many bank shares aren't yet cheap enough to compensate for negatives such as rising credit costs. "It's not a favorable time to make a bet," on Hong Kong-related banking stocks, he said.

Daryl Liew, head of portfolio management at REYL Singapore, said his fund doesn't hold any banks with heavy exposure to Hong Kong.

Prolonged unrest could further hurt the economy, he said, and "it's hard to see how the banks can continue to thrive when the broader economy is in the doldrums."

Write to Frances Yoon at frances.yoon@wsj.com and Joanne Chiu at joanne.chiu@wsj.com

(END) Dow Jones Newswires

October 27, 2019 12:59 ET (16:59 GMT)

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